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Secured and Unsecured Bonds

Bonds are issued be it in a secured or unsecured basis. A secured bond is backed up by the pledge of specific assets as collateral. For secured bonds bondholders can seize the assets after proceeding to court in the case of default.

Examples of secured bonds are the mortgage bonds (bonds secured by real estate), collateral trust bonds (bonds secured by assets owned by the issuer but held in trust by a third party), and equipment trust certificates (bonds secured by equipment).

How secured would you feel by holding a mortgage bond issued by a utility company that is backed up by the collateral of a power plant? During the utility bankruptcy do bondholders have the expertise to operate the power plant? Or can they sell off the parts on a piecemeal basis? Although the pledging of assets increases the safety of the principal of the bonds, bondholders should hope that the utility company does not default on its interest and principal payments.

Generally, bond investors should be more worried about the ability of the issuers to serve the debt (creditworthiness) before worrying only because of safety.

In case of bankruptcy, pledged property may not be marketable, and it may involve litigation, which can be time-consuming and costly. An unsecured bond is backed up only by the promise that the issuer must honor the compromises of the bond issue in discussion.

The ability of the issuer to pay fixed interests and repay the principal at maturity is based upon the issued creditworthiness. A bond issuer can make different issues in any moment. Each of these bonds can have different characteristics. When the issuer has many different bonds outstanding, seniority becomes important, specially during bankruptcy, due that senior bonds are the first to be repaid.

Junior bonds are unsecured bonds, and in a bankruptcy, debenture bondholders claims are secondary to secured bonds and senior bonds. The debenture bonds are unsecured bonds issued by corporations. In case of bankruptcy the debenture bondholders turn into general creditors of the company. Consequently, debenture holders assess the earnings power of the company as their primary security, which typically results in only well established and creditworthy companies issuing debenture bonds.

The subordinated debenture are bonds whose claims are taken into account only after the payment claims of the secured bonds and other debenture bonds are honored under a bankruptcy situation. The income bonds are the most junior among all the bonds, in which the issuer is only forced to pay interests when earnings allow them to cover these payments.